Real Estate Finance Notes 9/2/04


More on amortization


We went over the kinds of payment arrangements you can have with a mortgage.  There’s one more: you don’t have to amortize the mortgage over the term of the mortgage.  You can do smaller payments but then pay off the rest of the total as a lump sum at the end of the term: a “balloon” or “bullet”.  This is primarily done when you have seller financing due to the fact that interest rates are high or the buyer doesn’t have enough money for the down payment.  The seller will finance the purchase price, but will only agree to finance for five years or so.


When you start out paying a mortgage, you’re paying mostly interest and little principal, but then it gradually shifts over the term of the mortgage.  Each month, the interest is getting smaller because it’s calculated on the outstanding principal.  The interest is calculated each month based on what you owe at the time.  As you pay less interest, you take the difference and put it into playing for principal.  This makes up the amortization curve.  The slope of the curve is relatively flat at the top: you pay a lot of interest in the first few years and not so much principal.  But near the end, you’re paying primarily principal rather than interest.  You don’t have a month where you pay more principal than interest until you get a good ways towards the end of the term.  What does this say about refinancing?  People do it all the time.  When interest rates go down, people refinance.  But when you refinance, you move back to the beginning of the curve!  Remember that the interest is tax-deductible, while the principal is not.  If you refinance and don’t take cash out and you keep your payment the same, then you’ll end up better off: you’ll pay off the loan faster.  If you take money out, you’re even worse off: it’s like you go further back than where you started!


There is a very strong policy (that Braunstein doesn’t understand) in favor of encouraging people to buy houses.  The idea is that it’s good for people to own houses.  It may be good for people to own something, but why houses in particular?  Historically, it may make sense with World War II veterans needing a place to live.  We wanted to enhance their ability to buy houses.  You can argue that we overconsume housing: when you compare savings rates in the United States to savings rates in other countries, it’s lower, and one reason is that we invest so much in housing.  We do that, in turn, because the government subsidizes it.  Is this such a great place to invest money as a society?  It’s sort of a Jeffersonian democracy ideal: a farmer who owns his own land is a better citizen for being an owner.  But why is it so much better to own a house than to save money or invest in stock?  This policy is reflected in how to make mortgage payments smaller.


You can reduce your payments by reducing the amount of principal you borrow.  You could also try to get a lower interest rate.  There are many programs designed to reduce interest rates.  For example, the state borrows a bunch of money at 3-4% and then reloans it to home buyers for 4-5%.  The state makes a little money and the homebuyer gets an interest rate lower than what they would be able to get on their own.


Another way to make the interest rate lower is to have the Fed fiddle with the interest rate.  The interest rate equals the true cost of money (an absolutely safe investment, with no inflation, about 2-3%) plus the inflation risk plus the cost of credit risk.  The federal government may intervene to reduce the risk of certain loans by insuring them, shifting the credit risk from the mortgage lender to the federal government.  Note that there have been mortgage devices created to reduce inflation risk, like ARMs.  If you can adjust the rate of the mortgage every year based on an index, then you take less of a risk with respect to inflation.  Also, it doesn’t seem to make sense to pay extra for a 30 year mortgage when you’re only going to live there for seven years.


Also, the longer you have to repay the loan, the less you’ll pay every month.  However, the total cost of the mortgage will also be greater over the life of the loan.  You could also change the amortization rate so that your monthly payment is lower, but then you have the balloon/bullet coming at you at the end.


Structuring the transaction


What options do the parties have in terms of the particular transaction, say a house for $125,000?  First, you can have a cash sale.  Buyer gives the money, the seller gives the deed, the buyer records the deed, and that’s it.  Second, you could have a cash sale while paying off an existing mortgage.  The seller delivers the deed, the buyer pays the money.  Then the seller goes and uses the cash to pay off the mortgage.  The buyer could get a new loan and use it to pay cash.  The buyer secures the loan with the deed.  The buyer could also take over the seller’s old loan instead of having it paid off.  If the old loan was a good deal, the buyer may want to keep it alive.


You could also have seller financing, in whole or in part.  The buyer could pay a cash down payment plus a promissory note and mortgage for the balance in exchange with the deed to the property (encumbered by the outstanding mortgage).  In that situation, the seller wears two hats.  The seller basically is the same person as the lender to the buyer.  You could combine seller financing and taking over an existing mortgage.  If the buyer doesn’t have enough money for the down payment, the buyer might take over the existing mortgage and then have the seller finance the down payment.  The buyer could give the seller an additional note and a second mortgage.  “Second mortgage” refers to the priority with which the mortgagees get paid off.  These priorities are based on time.


Finally, we have wrapping around an existing mortgage loan.  The terminology isn’t really helpful.  This is really a combination of seller financing and keeping the existing mortgage in effect.  The difference is that the new mortgage is for the total amount that’s being lent.  The new, second mortgage will represent the total purchase price minus whatever cash is paid.  The second mortgage is for the full purchase price less the down payment instead of the difference between the existing mortgage and the new mortgage.  The seller has the advantage of being in control, because the buyer makes a payment that is sufficient to pay the old mortgage and the new one.  Then the seller pays the old lender.  The seller knows if payments aren’t being made and if a loan is about to go into default.  When the buyer does it, the seller may not find out about a default until it’s too late to do anything about it.  For a wraparound to be beneficial, you must be able to keep the old loan in effect, and that loan must have a lower interest rate than current market rates.  Both of those are highly problematic in the current environment: wraparounds aren’t important right now.


How does the seller make money on a wraparound?  The seller is really loaning $110,000 and really getting paid $885 a month.  What the seller is doing is not loaning his own money: he’s reloaning the money from the old lender at a higher interest rate.  He’s borrowing money from the old lender at a lower interest rate and then reloaning it at a higher rate.  If the old loan was at 7% and reloan it at 9%, then you’re making a lot of interest on the “new money”.  The return to the lender is quite high!  At the same time, the interest rate paid by the borrower is below market rate.  The borrower and seller do well, but the original lender suffers.  Lenders will object to this!  They’ll object to any situation where the buyer takes the property encumbered by an existing loan when rates have gone up.  These were very popular when it was harder for lenders to enforce “due-on-sale” clauses.  Now, this kind of financing has become less popular and valuable.


Schrader v. Benton


Schrader is the buyer and Benton is the seller.  The sales price of the condominium was $44,500.  They made a deal for $7,000 in cash and $37,500 to be financed in a wraparound mortgage.  There is an old mortgage to Amfac for $31,800, $7,000 in cash, and the wrap is $37,500 even though that’s not the new money being advanced by the seller.  How much money is the seller actually advancing?  He’s advancing $5,700.  If it were a cash sale, he would get $12,700, but in reality, with the loan, he’s only getting $7,000 cash.  So the new loan is only $5,700.  The loan was amortized over 30 years, but due in three years.  At the end of the third year, when the mortgage must be paid off, we find some of it has already been paid.  The balance on the mortgage at the end of the three years will be $36,657.  Payments have been made on the Amfac mortgage, and the balance of that one will be $30,181.  So the seller gets $6,476 in net cash.  Where does the $776 come from?  The Amfac mortgage is amortizing more quickly than the new wraparound mortgage.  The Amfac mortgage principal amount goes down by $1,600 while the Benton wraparound principal is only reduced by $843…the difference is the extra $776.  It’s a great deal!  It’s like a 20% return overall, even though they’re only charging 9%.


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